Stock Chartist

Commentary and recommendations about the stock market, sectors and individual stocks from a chartists perspective. Observations are based on the belief that "at their core, fundamentals are subjective but momentum is fact."

Main menu

Post navigation

October 25th, 2011

Mark Hulbert, in today’s Wall Street Journal’s Marketwatch blog asked the provocative question: “Did Monday’s strong market action satisfy one of the official definitions of a bull market?” His answer was “Believe it or not, the answer is yes — at least for some market indexes and some definitions. Which is remarkable, given that just three weeks ago another market index satisfied another of the official definitions of a bear market.”

The signal to which he referred was the Index crossing above the 200-dma. He writes further that “crossing the 200-day moving average is not the only definition that analysts use to determine a shift in the market’s major trend. Still, this trend-following indicator has a respectable record at anticipating shifts in the market’s major trend.”

In my market timing studies I’ve found that:

market timing is a too imprecise practice to be binary (all-cash or all-in, bear or bull, yes or no) and

a combination of indicators is more effective for market timing than any single indicator alone.

For example, in developing my Market Security Meter based on nearly 50 years of market data, I found that (as quoted from my upcoming book, Run with the Herd):

“….a neutral, unmanaged buy-and-hold strategy delivered $17,022, or a compounded average annual return of 6.20% over the test period between March 12, 1963 and December 31, 2009. Applying the 200-dma market timing rule to that same hypothetical portfolio over the 46-year period improved the results marginally and delivered an ending portfolio of $21,938, or 6.62% compounded average return before considering taxes, interest and transaction costs.

Selling when the Index crosses below the 200-dma is a simple rule that marginally improves total long-term results but it has disadvantages. For one thing, it works best in secular, or long-term, bull markets as contrasted with markets that have shorter-term (2-3 year) fluctuations like the period between 2000 and 2010. Over the 45 years in the database, the indicator suggested all-cash positions 33.4% of the all trading days….

The strategy produces a marginal improvement but not one that would have made you rich. You would have avoided some losses and wound up with a $4,748 higher ending balance. “

The problem with the indicator is that it over-prescribes an “all-cash” positions, periods when investors who follow the rule are out of the market when they should actually have been fully invested.

The problem can be remedied by combining the 200-dma rule with another common indicator and moving into an all-cash position only when both selling rules simultaneously proscribe an all-cash, risk-off posture. Only when the signal of one of the rules confirms the other should you actually assume the worst.

I combine the different configurations of these two indicators (plus some minor tweaking for instances that fall between them) into what I call a Market Security Meter:

The Index crossing above the 200-dma did actually change the color of the signal from Red but it surely didn’t cause the light to turn Green.

Subscribe below or click here to learn more about help for navigating turbulent markets.